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OK, currencies are difficult.
Firstly, it’s been hard — nay impossible — to build a trading model that delivers strong and consistent results over time, even with perfect macroeconomic, bond, and equity market foresight.
Most people that trade currencies deploy a variety of models. They tend to use some mix of real and nominal interest rate differentials, purchasing power parity and real effective exchange rate mean-reversion, relative economic growth prospects, central bank balance sheet size, etc. The list, if not endless, gets long quick. You can pretty much always justify what has recently happened with reference to one of these frameworks. But working out which framework to apply ahead of time is a dark art.
Secondly, at a more basic level, it’s sometimes hard for people to know even if their currency is strengthening or weakening. This is — to state the obvious — because currencies are traded as a ratio against other currencies rather than as an absolute price.
Sterling’s strength — or lack thereof — has attracted keen political interest ever since the UK’s decision to leave the European Union in June 2016. As Theresa May shifted towards a ‘hard Brexit’ in October 2016, it was easy for her political opponents to point to sterling’s tumble against the dollar (from $1.34 to $1.21) and against the Euro (from €1.19 to €1.11) as evidence of the market’s concern.
But by the time sterling hit its intermediate nadir against the euro of €1.07 in August 2017, it had rallied to $1.29 against the dollar, leaving those same opponents scratching their heads as to how to parse this data to their advantage.
Broad effective exchange rate indices (ERIs) seem a sensible way to deal with this problem. They are actually quite complicated to estimate. But they are super-easy to chart. And while sterling’s ERI is definitively not just an index consisting of 60 per cent euros and 40 per cent US dollars, assuming that it is works most of the time.
Source: Bank of England, FRED
Unfortunately, unlike equity indices, currency indices don’t mean much to people. There weren’t many headlines about Sterling’s broad effective exchange rate index weakening from 76.2 to 73.7 in the wake of the Truss/ Kwarteng mini-Budget. In contrast, a dive towards cable or euro parity resonates. If you happen to be the prime minister of the day this can be understandably upsetting.
After much head-scratching Alphaville has found a solution to charting this complexity. Unfortunately, the solution involves a chart that is . . . complex?
Behold the sterling vs euros vs dollar chart with diagonal gridlines! To more easily read it we’ve rotated the axes so that (some of) the gridlines are horizontal. And we’ve grouped values by prime minister of the day, stretching back to Cameron.
Taking the heuristic that sterling’s broad effective exchange rate can be proxied to a 60:40 mix of euros and dollars, we’re able to construct a series of lines that run horizontal on the rotated chart (north-west to south-east on the unrotated version). Sterling moves left to right along these horizontal lines could be fodder for headline writers but are in fact manifestations of changes in EURUSD. They will probably be impactful for sectors of the economy, but are not really indicative of either sterling strength or weakness.
The (sort of) vertical lines on the rotated chart (that run south-west to north-east on the unrotated version) show where sterling crosses fall for each given level of EURUSD. Sterling can travel up or down any of these lines without the EURUSD rate changing a basis point. Such moves show genuine sterling strength or weakness in action.
Obviously, now that this new way of charting sterling’s moves has all been laid out, Alphaville fully anticipates it catching on.
